Short attacks!

I wasn’t intending to write a post this week as I am still very busy with other engagements at the moment. However, after the dramatic short attack on Burford Capital last week, which until quite recently had been one of my largest positions, I’ve decided to record my thoughts and a number of recent trades.

A lot has happened since my last trading update a couple of weeks ago.  Looking back at that post, the signs of hubris were evident as I congratulated myself for my recent avoidance of profit warnings and set out my thought process behind my next trade in more detail than I normally would. Sopheon was at the top of list of candidates to sell and my intention was to sell it that week. As fate would have it, Sopheon released an unexpected profit warning the next day, forcing me to crystallise a 6% loss on a position that had previously been in nice profit. I bought RELX in its place.

That week was also the week of Burford’s much-awaited half year results. I was holding a large position in Burford, despite a stagnant share price, on the expectation that the half-year results were likely to sparkle and get the share price moving up again. And it did for a very brief period, before dramatically reversing, despite the results looking very good and management expressing ‘unbridled optimism’ at future prospects. I took this unexpected price reaction as a red flag and after a bit of mulling over, decided to sell two thirds of my uncomfortably large position at break even.

Following last week’s events, this has turned out to be a good decision (well quite good – even better would have been to exit completely). I sold the rest of my holding (realising an overall 12% loss) after a quick skim of the Muddy Waters report on Wednesday morning, as the allegations of fraudulent accounting seemed specific enough to cause a panic. And that they did, in quite spectacular fashion!

When I’d had a chance to read the report properly near the end of the day, I found it less convincing. In particular the final section, criticising Burford’s overall approach to accounting for realised versus fair value gains as misleading and alleging ‘arguable’ insolvency, appeared for the most part nonsensical and intentionally deceptive. However, the MW report does raise a few points of substance. The main ones I took away were that:

  1. Burford has ample scope to manipulate the timing of when it recognises gains and losses. This is the thing investors should be most worried about, as it creates the potential for a Ponzi-like dynamic where profits are brought forward increasingly aggressively to maintain an overstated growth rate. There is risk that Burford could overstate returns for a considerable length of time before being found out. While this risk does affect the investment case, I don’t think there is evidence to suggest Burford has been significantly overstating returns in practice.
  2. Profits in litigation finance come disproportionately from a small number of big-ticket cases. While this raises Burford’s risk profile and creates the potential for lumpy returns, it also implies that there may be significant competitive advantages to scale in litigation finance – something Burford should benefit from. I would expect these advantages to come from multiple sources: greater ability to diversify across cases, greater ability to gather experience and data on litigation outcomes and greater ability to exploit reputation to cherry-pick the best looking cases.

These were both points I was already conscious of, though the MW report has prompted further thought on my part. Overall, I still like the business but am more cautious about the valuation it should trade at.

With the price near £6 and the reward to risk looking very appealing, I felt compelled to buy back in last Wednesday afternoon, though I kept the position smaller (2% of portfolio) this time. Burford’s rebuttal on Thursday seemed solid so I’m optimistic, though not in any rush to add for now. There may be more mud-slinging coming up and I’m wary of becoming overly confident that none of it will stick. Burford issued an RNS on Monday about its investigation of possible market manipulation, focusing on possible ‘spoofing’ and ‘layering’. I can’t say I find it terribly convincing – the allegations seem speculative to me. More importantly, this seems tangential to the claims made in the MW report.

I ended up making another two trades this week. I traded Kering for Esker last Monday as my regular trade (before I was aware of the Burford short attack), realising a 15% profit on Kering. Momentum was weakening at Kering following signs that growth of its Gucci brand might be slowing faster than anticipated and the reemergence of trade war fears. In the chaos of trading Burford, I inadvertently ended up making another trade – I first swapped Burford for Boohoo then needed to sell something else to buy Burford back again. I decided on DotDigital, realising a small 8% loss, as it seemed to have the weakest momentum.

On a more positive note, two stocks I hold have recently jumped up on positive news: LSE on news of its plan to acquire Refinitiv in a huge reverse merger and Match on an excellent set of results.

So on to a quick profile of my new purchases, RELX and Esker. I won’t profile Boohoo as it is a very familiar name that I have bought back into as it approaches all-time highs, having this week announced its acquisition of the Karen Miller and Coast brands.

RELX

RELX

Relx provides information and analytics services to businesses in various sectors. These services include a broad portfolio of academic journals where primary research is published as well as various databases and decision tools based on them. Most of Relx’s services are provided on an ongoing subscription basis. It is a favourite of UK ‘quality investors’ – both Nick Train and Keith Asworth-Lord have RELX in their portfolios. It’s definitely not a hugely exciting prospect but is intended to add defensive ballast to my portfolio.

Quality

  • Business economics: RELX is a capital light business and is consistently very profitable, with operating margins consistently around 25% (and slowly growing) and returns of capital currently at 22%. RELX uses some leverage to generate returns on equity that are considerably higher (currently around 70%).
  • Track record: RELX has a very solid track record of consistently growing revenues and profits.
  • Competitive advantage: RELX has a very diversified business offering a broad range of services to a broad range of sectors. This makes it quite hard to assess its competitive position in much detail. However, I’m pretty confident that RELX has very strong competitive advantages in most of its markets. In most cases it seems to be the number one or number two player in terms of scale. There are likely to be very significant scale and scope advantages derived from the gathering and processing of data and IP necessary to provide RELX’s services. These services also seem likely to have the attractive characteristic of being important but low value from the perspective of RELX’s customers, making them less likely to want to switch. All of this means it is hard to see new players successfully breaking in to its markets. This gives me some confidence that RELX’s future growth, while likely fairly modest, should be relatively certain.
  • Growth prospects: RELX is definitely more of a steady compounder rather than an exciting growth story. Its markets should continue to grow modestly but steadily over the long term and RELX seems likely to be able to take advantage of its pricing power and operating leverage to grow profits at a somewhat faster rate.

Price

Share price momentum is strong with the price near highs. I bought RELX shortly before its interim results, which seemed decent to me but were not terribly well received by the market at the time. The share price has recovered since. The valuation seems reasonable.

esker

Esker

Esker is a French Enterprise IT business. It specialises in document process automation software, part of which is commonly known as procure-to-pay (P2P), to enable businesses automate how they invoice and collect from their customers and pay their suppliers. Most of its sales are concentrated in Europe (particularly France), though it also does a reasonable amount of business in the US.

Quality

  • Business economics: Esker has decent profitability with returns on capital around 20% and an operating margin in the low teens. It is currently in a high growth phase and is investing quite heavily in product development of its ‘Esker in Demand’ SaaS (software-as-a-service) product. I would expect profitability to rise over time. Esker has a healthy balance sheet with net cash.
  • Track record: Esker has an excellent track record of steady but fairly rapid growth in profits.
  • Competitive advantage: Esker is transitioning to a fully subscription model and a high percentage of its revenues (80%) are recurring. Document process automation seems similar to other enterprise software like payroll processing, in that the need to avoid disruption means that switching costs are high. These would insulate Esker from competition to some extent. Esker does face competition from other larger players, e.g. Coupa and Basware. However, switching costs, the focus of its sales in Europe and the fact that Esker’s proposition is differentiated from competitors (e.g. it describes itself as unique in offering inbound and outbound document processing) should provide adequate protection from competition.
  • Growth prospects: with the overall market likely to grow for many years yet and Esker performing strongly, the growth prospects look excellent.

Price

Momentum is very strong with the share price near highs and Esker’s last trading statements being very strong. I’m particularly attracted by the very substantial increases in new contracts signed that haven’t yet been recognised as profits. The valuation is high but I think warranted by the excellent short and long term growth prospects.

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